And the higher they are, the harder they fall
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Sep 02, 2020 • • 4 minute read
We are in a huge bubble now. Vaccine or no vaccine. Economic and earnings recovery or not. With or without the massive monetary creation by the U.S. Federal Reserve. This is a bubble of historic proportions.
Some will say that the valuations are supported by interest rates. Frankly, real 10-year rates moved into negative terrain in January, before the stock market plunged and before the recession began. Now, they have become even more negative.
There is actually no such thing as a free lunch and the thing about negative rates is that they coexist over time with a flat economy. And that economy is where earnings are derived from.
Don’t be fooled by the fact that the monthly U.S. data are beating “expectations” (like earnings). At the margin, economic momentum is starting to wane in the more up-to-date data. The bounce we saw previously in consumption growth is ebbing. Initial U.S. jobless claims are back rising at a one-million pace over the past two weeks. The latest information on mobility, retail traffic and airline activity has softened, and bankruptcies are mounting.
The other reality is that positive real rates tend to coincide with real growth of three per cent, or better, historically. Yes, the discount rate inflates the present value of those future earnings streams. But these same rates tell us that the profit growth itself before the discount factor is applied is going to be anemic for a long period of time. You can’t have it both ways.
That said, the bulls are in charge. The market is always right, so they say. Indeed, it was right in September 1929 and then right again a month later. It was right in September 2007 and then right again a month later. It was right in February 2020 and also right a month later.
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It’s not even so much about being right. It’s more about the assumptions that are underlying the price action at any given moment in time. And we are back to being priced for perfection and the complacency is a major concern to us.
You know we are in a truly abnormal environment when the market in the past was less pricey more than 99 per cent of the time
Valuations are at extreme levels. No matter what decision you make, know that. The S&P 500, on a trailing basis, now has a 27.4x price-to-earnings multiple. Only 0.4 per cent of the time in the past 70 years has the multiple been so rich. On a forward 12-month basis, only 0.1 per cent of the time has the market been more extreme than its current 23x. As for the Nasdaq, it, too, is in the top one per cent of valuation rankings ever recorded.
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The smoothed cyclically adjusted PE ratio (CAPE) multiple says the same thing. It never did actually compress to a normal recession-trough multiple in March: it briefly touched 24.8x and has since jumped to 30.6x. It is almost back to the 30.7x peak it had in February (ahem) and the prior peak before that in October 2018 when it was as high as 31x (next thing you know, we are in for an unforeseen near-20-per-cent correction).
The current multiple actually exceeds the 27.3x peak of October 2007… and we know what happened next. Before the tech mania, that is, before June 1997, not once did we have the CAPE north of 30x for one month, until we go all the way back to September 1929 (32.6x).
This isn’t to say something calamitous is going to happen. But this market is trading at dangerously high valuations should anything — financial, economic, political — not go according to plan.
The higher they are, the harder they fall. There is no margin for error here and history shows multiples at these levels leave the market exposed compared to when they are at more reasonable or normal levels. It should go without saying that you know we are in a truly abnormal environment when the market in the past was less pricey more than 99 per cent of the time.
Valuations matter until they don’t matter and by then it’s too late. Or, as Wall Street veteran Bob Farrell put it, bull markets can go further than you think, but they don’t correct by going sideways.
Once the Chuck Prince dance-a-thon ends — and it will, we just don’t know when — you do not want to be standing too far from the exit signs.
David Rosenberg is founder of independent research firm Rosenberg Research & Associates Inc. You can sign up for a free, one-month trial on his website.
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